Global bond markets seem determined to fight the last war. Having ignored the debt build-up that brought down the US financial system in 2008 and crippled the European periphery in 2010, debt phobia is now imposing excessive austerity on key advanced countries which should be growing faster. Moreover, this debt paranoia is constraining emerging countries from borrowing more.
If this debt angst could be lessened, emerging countries could redress their infrastructure deficiencies while at the same time boosting world demand.
Since 2008 bond markets have been in confusion, swinging from 'risk-on' to 'risk-off' assessments on the basis of trivial and ephemeral news. Perhaps it's not surprising that financial markets have trouble assessing the fundamental valuation of bonds. The economic conjuncture is hard enough to assess. How long will Europe's stagnation last? When will US growth lift from its current lethargy? How will Japan handle its debt mountain? Adding to these uncertainties, active policy intervention means that the fundamentals are overshadowed by policy responses: it's not just the trajectory of the economy that matters, but how policy responds.
The widespread resort to quantitative easing (QE) presents the main policy uncertainty. QE was originally envisaged to operate mainly by lowering bond yields. While bond yields certainly came down, this largely happened when QE was not active. Instead, the main impact of QE has been to boost equity prices and lower exchange rates. These expectations are volatile and unpredictable, driven by what Keynes called 'animal spirits'. Moreover, many market participants believe (wrongly) that QE is 'printing money' and that this will inevitably drive up inflation, which is bad for bond holders. Others fret about the inevitable day when QE is phased out.
Thus the bond market spends more time double-guessing future policy than analysing the underlying economic fundamentals. US Fed chairman Ben Bernanke startled global markets last week when he gave an ambiguous reminder that QE was not a permanent state of affairs. In Japan, BoJ Governor Haruhiko Kuroda had to steady bond markets with a promise that he would support the market as necessary. And in Europe, the only reason bond yields have returned to non-crisis levels is the promise by European Central Bank president Mario Draghi to 'do whatever it takes' to hold the euro together.
In this febrile environment, bond markets are not playing their fundamental role: shifting long-term funds from cautious investors to borrowers who are in sound shape and able to make good use of these low-cost funds. The global economy currently wants to save too much, leading to deficient demand. A well-functioning bond market would help channel this saving into investment. The intermediation role of the bond markets has been choked by excessive caution.
Both the UK and the US governments have responded to this debt paranoia by sharply cutting their budget deficits in the past three years, and both have paid a heavy price in terms of a lethargic recovery. The alternative would have been to put in place a credible two-stage budget plan under which austerity would be delayed until the economy was back on its feet, addressing the debt issue only when economic activity was strong. Belatedly, stimulatory capital spending is being advocated in the UK. The damaging impact of the debt fixation is demonstrated in the hare-brained schemes to use central bank funding for budget stimulus, motivated by a false belief that this sidesteps the constraints of the debt ratio.
Meanwhile, since the 2008 crisis, bond markets in emerging countries have been attracting more interest from advanced-country investors. Bond investors saw attractive returns, strengthening exchange rates and steady growth prospects offered by these still-vibrant emerging economies. Even as European banks retreated from these economies, bond markets took up the slack and more. This enabled the emerging countries to expand their investment (including infrastructure), one of the few bright spots in global trade.
But more recently the same Nervous Nellies who produced such volatility in European bond markets are sowing seeds of doubt about these flows to emerging economies, using the same simplistic analysis about 'debt binging'.
Yes, this expanded investment does mean that debt/GDP ratios are rising in emerging countries, and their current accounts are moving into deficit. And yes, it does mean that if financial markets suddenly take fright and withdraw their funding, these recipient countries have a painful adjustment ahead. But a deeper analysis would assess these flows, and this debt, as being quite different from the excessive borrowing of Greece and Spain. If these flows fund productive investment, then this borrowing doesn't weaken the balance sheets of the borrowers. This is, in fact, exactly the rationale for expanding and deregulating financial markets: so viable opportunities could be funded and balance sheets could expand.
How could this debt constraint on the weak global recovery be eased? It might help if those countries which have undertaken substantial QE set out more precisely how these operations will be unwound. They may not be able to specify the timing, but the market is still uncertain about the mode. As well, international analysis (in the IMF, the World Bank and at G20) could offer support and a longer-term perspective for capital flows to emerging economies, endorsing these flows as a sensible and sustainable response to a global demand deficiency.
Photo by Flickr user stuant63.